Option Investor

Covered-Calls 101

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Some Thoughts on Risk and Reward.

Risk is a fact of life for everyone and it is important to consider the possible losses along with the potential rewards when choosing a specific trading style or technique. Different strategies have varying levels of risk and understanding this concept is the first step to long-term success. Obviously, you have to assume a certain amount of risk in order to earn a reward thus the key to profitable trading is to minimize your exposure to the perils of the market and that typically involves utilizing methods which yield lower returns. Because some techniques are simply not appropriate for all traders, another essential step in determining the best way to approach the market involves identifying your personal comfort zone or risk-tolerance level. Many of the best option traders earn the bulk of their annual profits in just a few plays but is that the right style for you? These professionals comfortably accept the possibility that the value of their portfolio will rise and fall substantially over very short periods while others quickly panic and bail-out of the market at the worst possible instant. This range of emotional endurance is why the tolerance for risk varies so much from person to person and it also changes over time, based on each individual's financial circumstances.

The ability to correctly assess risk is a core proficiency of any effective trader but history suggests that many market participants are woefully inadequate in this regard. For this reason, all but the most experienced options players should focus primarily on techniques which generate consistent returns with relatively low capital risk. One of the most popular strategies in this category involves writing in-the-money covered-calls against long stock positions purchased specifically for that purpose. Although success with this type of approach is based on forecasting trends in stock prices, the sale of option "premium" improves the probability of achieving a limited, but acceptable profit. In addition, the shareholder retains any dividends issued on the stock before the option is exercised and these gains can significantly increase the annual return of covered-call positions.

Despite the attractiveness of this strategy, some people simply can't accept the fact that earning 3-6% on a monthly basis is a favorable return and one that will generate wealth in the long run. The catalyst for this prosperity is compound interest; a function of capital accumulation that has been described as the "greatest invention of mankind." Of course, we all know how it relates to our savings accounts and mortgage loans but novice traders often fail to comprehend its subtle, long-term affect on their portfolio value. As an investor, you benefit financially from compound interest when you reinvest not only the original capital, but also the returns from each successful trade. The total profit you earn on your investments will vary based on the gains from each trade and on the number of times you achieve that return in a given time period. Most people are surprised to learn that a 6% monthly return is roughly equal to a 100% yearly profit after adding the gains from compounding. Another bonus is that, unlike a bank account, you do not have to reinvest the profits in the same instrument (such as a savings account), but rather you can move the money from stocks to options or other issues as opportunities present themselves. This means you can diversify your portfolio as well as compound the returns.

Obviously, anyone who has followed the market in recent years knows that stock prices do, in fact, move unexpectedly and that is why it is so crucial to use a strategy with a large range for profit. In addition, it is important to enter new positions only when the conditions are optimal. That means initiating a trade when favorable technical or fundamental indications are present and there is a relatively high probability of a reasonable profit. Finally, it is essential for the position to be one in which the individual feels comfortable, not only in terms of the initial cost or margin requirement, but also with regard to the underlying strategy and its overall risk characteristics. The sale of in-the-money covered-calls is a good technique in all of these respects however there are always risks involved, thus anyone who is not absolutely convinced about the outlook for a specific candidate, or who is not completely knowledgeable about a particular strategy (and the potential adjustments), should not initiate a new position until those issues are resolved. Trading just for the sake of being "in the game" is never appropriate and although it is difficult to remain on the sidelines when others are talking about recent winners, the consequences of careless decisions can be financially devastating to participants who ignore the reality of the stock market.

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